Mazars Quarterly Investment Outlook: Whatever Happened to the Global Synchronised Cycle?

Mazars Quarterly Investment Outlook: Whatever Happened to the Global Synchronised Cycle?

Tue 23 Oct 2018

Read our full Mazars Quarterly Investment Outlook – Q4 2018

Global Divergence

In an early 2010 report Morgan Stanley warned that the biggest consequence of the 2008 global financial crisis could be isolationism and the reversal of a 50 year old trend which saw increasingly open borders, open trade and freedom of movement. As each country would seek to leverage its position to avoid the worst consequences of the crisis, the strong would get stronger and the weak would get weaker. At the time, few key central bankers in the US, Japan and Europe saw the risk. Taking a page out of game theory, they decided that it was in their interest to cooperate and restore growth, rather than compete for a quickly dwindling output. However, as power eventually passed back from central banks to elected officials, and as the electorate was more interested in localised rather than global growth, the desire for convergence soon turned to divergence. As cooperation diminishes, the world finds itself struggling with the rebalancing of the relationship between its two largest single economies, the US and China.

The main theme for investors since the beginning of the year has been divergence. As global growth for developed markets remains well below its pre-crisis norms, nations are turning inwards to find solutions which will allow them a bigger share of the global economy. A formerly cooperative process leading to a rapidly globalised economy is now increasingly turning into a zero-sum antagonistic game, with clear winners and losers. This development is underpinned by persistent trends:

  • America’s diminished desire to share its modest growth with the rest of the world
  • The rebalancing of its relationship with China
  • A developed market electorate disenchanted with the benefits of globalisation
  • A retrenchment of central bankers who now see their role within the more traditional confines of fighting inflation through monetary policy rather than stewards of growth.

But what do trade wars and growing differentials in policy stimulus mean for investors? Increasingly more divergence. Year-to-date, global stocks have risen 6.2%. However, take out the US, and growth for the MSCI World is 1.38%. As US stocks rallied, European growth petered out, the Chinese stock market plunged into a bear market, while Turkey saw its currency depreciate by 40% since the beginning of the year. Valuations also diverge. The US is trading significantly above its historic premium versus the MSCI World (6.25%), while the UK is trading below (-5.27%). Europe is also hovering above (4.77%) even as Emerging Markets and Japan trade below their average valuations over the past few years (-11.3% and -27% respectively). The Dollar rose as much as 1.5% on a trade weighted basis, while the Euro was flat and the GBP has weakened 1% as Brexit worries compound ahead of a critical deadline in March 2019.

As asset allocators we welcome divergence, since it creates opportunities, especially for active managers. However, we are increasingly concerned that those strengthening headwinds could eventually harm the economic cycle, already in its tenth year. Thus, this quarter, we set out to examine the sources and repercussions of the growing divergence between global economies. Is the divergence a normal, cyclical phenomenon, or is there more to it than meets the eye?

A brief history of asset allocation

Until the 1950s, allocating wealth was primarily a business for stock brokers. Clients would step into a well decorated Wall Street office and ask to be informed of the best stock picks, which would subsequently constitute their portfolio. During that time bonds were rarely part of the discussion. At that time, the corporate credit market was still underdeveloped (from a few billion in 1950 to over 3 trillion Dollars today) and, as was the case with sovereign bonds, reserved for pension funds, institutional investors and retirees.

This all changed in 1952, when Harry Markowitz published his paper “Portfolio Selection”. It was the first time someone saw financial assets in a holistic risk/reward way, rather than just a collection of separate stocks. His work earned him the Economics Nobel Prize in 1990. In his Modern Portfolio Theory, Markowitz argued that portfolios should include different assets that on average move in different directions to improve their reward/risk profile. When stocks go up, for example, bonds tend to retreat and vice versa. So why not have both? While this would limit the upside, it would also cap the downside.

That was exactly what the financial industry was looking for; a way to tell its clients that the downside can be limited. At the time the industry was coming out of the Second World War and was still reeling from the painful memories of the Great Depression. Desperate to shed their pre-war image as shady back room dealers and re-entice clients with safer methods of investing, financiers quickly adopted Markowitz’s theories, rebranding themselves as custodians of wealth. Thus, asset allocation, the bedrock of portfolio management, was born.

Asset diversification during the Global Financial Crisis

Portfolio management to this day adheres to that same principle: returns can be maintained and overall volatility reduced if one holds differentiated assets. Asset managers create diversified portfolios which include many different asset and sub asset classes. Yet, that tenet was seriously challenged after the Global Financial Crisis (GFC). In the aftermath of Lehman’s collapse, central banks took the reins of the global economy and, in concert, bought financial assets, infusing the global financial system with over $8 trillion of new wealth. All financial assets rebounded sharply shortly after so-called “Quantitative Easing” (QE) began. With the exception of the 2011-12 Euro Crisis it was very easy to invest across the globe, with most investments gaining, underwritten by central bankers determined to support the risk/reward culture. Global economies also rebounded in a synchronous manner, as new money meant new investments, some of which trickled down to end consumers.

The system was saved. But Modern Portfolio Theory, which suggested holding both equities and bonds to benefit from the low correlations between the assets in times of stress, was tested. If asset classes across geographies gained synchronously, it stood to reason that they would lose synchronously.

2015 onwards: Divergence

Much changed after 2015. As Europe was beginning a QE cycle, the US was nearing the end of its own extra-ordinary monetary stimulus.

Four types of divergence emerged:

  • Political Divergence
  • Economic Divergence
  • Market Divergence
  • Eastern-Western divergence

Political divergence

Now central banks are seeking to give up the driver’s position, leaving further stimulus dependent on fiscal policy, which is in the hands of elected officials. This, however, may not have been enough. Central bankers control monetary policy and oversee the banking system, but have no means to decide on the dissemination of the capital they create. In other words, quantitative easing found a way to create over $8 trillion of non-inflationary new wealth, but its instigators could not control where the money went. Banks initially used the money to cover the gaping holes in their own balance sheets. But the money kept coming in well after the financial system was repaired and re-regulated. So it was financial markets which benefited, with asset prices rising rapidly. Yet consumers, most of whom own real rather than financial assets, saw little benefits from the stock market rally.

The global economy subsequently fell victim to an economic notion known as the paradox of thrift: consumers, weary of the crisis, were not willing to increase their spending even when their finances allowed them to. Companies, aware of the fact that the global economy was artificially propped up by the central banks and fearing diminished consumer demand going forward, cut back on their spending, preferring high dividends and share buybacks to expansion of their operations. Some opted for spending money to acquire rival companies, but M&A is all about cost-reducing synergies, not about expansion.

Thus, the most disconcerting divergence, which still undermines the economic cycle, was born. Political divergence. As owners of financial assets, usually the wealthier percent of the population, was getting richer on virtually free central bank money, average families on Main Street saw their own lives stagnating. To the electorate, the system may have saved itself, but it was no longer necessarily working for them.

Enter an era of political divergence, the likes of which have not been observed since the 1930s. Two notable rifts have been rocking the political world in the past few years: The rift between the more and the less affluent and the rift between importing and exporting countries. The former exacerbates the latter.

The PEW research centre discovered that in the US, the divide between Democrats and Republicans has significantly grown in the past 20 years. In Europe, the situation is similar. Electoral cycles have seen the simultaneous rise of both the hard right and the hard left, confirming that the wind is only blowing against centrist policies.

Markets have usually been sanguine about politics. However, this time around, the politics of disenchantment matter. The post-crisis malaise has exacerbated political tensions across the world, with electorates now increasingly choosing representatives who promise prosperity to their voters, rather than pledging themselves towards a stable global economy. Brexit and the election of Donald Trump cemented that trend in the Western World, as the UK and the US both decided to seek more domestic-based economic growth policies. As politics diverged, so did the return of risk assets and economic growth. In Europe, Italy’s politics of dissent put additional pressure on the very fragile European experiment.

US Dollar assets benefited massively from Mr. Trump’s repatriation incentives, including a massive tax stimulus for US firms, with investors liquidating riskier positions around the globe, such as in Emerging Markets, to invest in US Dollar equities.

Economic Divergence

Divergence in politics is reinforced by divergence in monetary policies, with central bankers now taking more cues from political leaders, rather than other central bankers. While the US is hiking rates, the EU and Japan has maintained its ultra-accommodative policy and UK rates continue to remain near all-time lows.

Global trade conditions have deteriorated, mostly due to the stronger dollar. A more expensive global reserve currency is a disincentive for trading goods and services. Since last year, the growth of world export volumes has fallen an estimated 6%, while Korean exports (a traditional bellwether for global trade) have slowed by 8%. Despite the tightening in the US, financing conditions in most developed economies remain relatively loose. However, key Emerging Markets, such as China, are reporting significant tightening in credit.

Different countries now pursue growth in different ways. The US stimulated its economy, possibly at the expense of future growth. Mr. Trump’s Republican government cut taxes and instituted incentives for currency repatriation. It is also pursuing, and achieving, an overhaul of tariffs with its neighbours, while taking a more antagonistic approach against the EU and China. As a result, US growth picked up in the last quarter, with the economy gaining 2.9% year on year, up from 2.6% in the previous quarter, while corporate earnings rose over 20% for the second straight quarter. Business and consumer confidence is soaring, confirming the Fed’s hawkish bias, as inflation is tightening. The Fed’s Chair was even quoted saying that he “would see no reason why the cycle should not go on indefinitely”.

Europe on the other hand, still employs Quantitative Easing to ease pressures created by its ever-unbalanced economic ecosystem, while avoiding stimulus as countries are forced to adhere to strict deficit rules. German, French and Spanish exporters may benefit from an occasionally lower Euro, but most peripheral countries, including Italy, continue to struggle to find a viable long-term economic model within the confines of the single currency rules.

Aggregate European growth has slowed from 2.2% to 2%, a trend reflective of most economies within the union. France’s economic momentum is lost, Spain is slowing and Italy continues to wrestle between the need for reform and a new political direction. Meanwhile, inflation is creeping up, however the ECB does not expect to consider interest rate hikes until mid-2019.

The British economy continues to slow down, although an unexpectedly good summer saw an equally unexpected pick up in consumption and construction. However, overall output continues to decelerate to almost half the pre-referendum levels. GDP growth registered a 1.2% rise in Q2, against 2.4% in 2015, while inflation persists at levels above 2.5%, prompting the central bank to have a more hawkish outlook, despite diminished demand.

China continues to carefully stimulate parts of its economy, while simultaneously proceeding with a controlled deflation of its local and private debt. In the past few years, Chinese companies are catering more to the domestic consumer, rather than just being reliant on exports, which also means a more domestic-focused economic policy. Official growth is still strong (c. 6.7%-6.8%) however evidence from PMI indicators suggest more sluggish output.

Market Divergence

The economic divergence was concomitant with broad market divergence. During the second half of the year, risk assets decorrelated further, as it became apparent to investors that the factors underlying economic divergence would persist for some time.

A major area of divergence is currencies. As the US has continued to tighten its policy, yields have risen above the critical 3% level, above which the interest of long term investors increased. After almost a decade of yield suppression, the opportunity to invest on the world’s “risk free asset” at a decent yield was too big for investors to pass, which led to outflows from the riskier Emerging Market positions and inflows in US Dollar assets. For the year, USD has gained 3.5% on a trade weighted basis, Yen has gained 2%, EUR is down 2.2%, GBP is flat, while a basket of emerging currencies has lost 12%.

In terms of stock markets, divergence features not only in returns but also in valuations. In Sterling terms, US equities have returned 13% for the year, pulling the MSCI World up with them. However, in same currency terms, UK stocks have returned -1.5%, while European, Japanese and Emerging Market stocks, unaffected by significant local factors such as Brexit, have returned -2.6%, +2.8% and -9% respectively.

Research indicates that the current bout of divergence is actually nothing new. Such market divergence happens often, and if anything, convergence at the beginning of the year was actually near historical highs. However, the significant headwinds to global economic convergence, a consistent post-World War II trend which has now come under threat, sheds more light onto the recent diverging trends.

EM DM rebalancing – China’s role

One of the major, but less acknowledged, drivers behind the rift is the emerging/developed market rebalancing. In the past, Asian companies, primarily China and Japan, produced cheap goods for Developed Market consumers. Asian economies were growing fast, while DM consumers were benefiting from cheaper goods. The relationship began to change in 2014, when Chinese authorities decided the time was ripe for their economy to make the leap from the secondary (manufacturing) to the tertiary (services) sector. This, naturally, shifted the focus to domestic consumers, as proximity is a significant factor in consuming services. The next move came from the US, which set up the TPP, a Trans-Pacific Partnership, which solidified its foothold in the area. We view the subsequent change in policy under Mr. Trump, as simply a different, more antagonistic version of that move.

Despite the disruption, Chinese economic transition is expected to persist, which means that the two biggest single economies in the world will have to find a new way of working together. The process could take from as short as two weeks to as long as decades. In the meantime, the progress towards globalisation, which began after WWII, could see its fair share of disruptions.

Is globalisation unwrapping?

The question underpinning diverging trends is this: have we reached the limits of globalisation? Do financial services and technology move at speeds at which modern men and women simply cannot follow? Is the current diverging trend simply the return trip in a process which began with the kick off of the cold war?

So far, we do not have the evidence to call the end of globalisation. The ability to trade goods and services without borders is facilitated by technology. In a predominantly capitalist world, why would anyone seek to forgo technological advances and pay more than they should have to? In contrast to individual interest is of course societal interest, which increasingly takes the form of populist movements, which would put “America First”, or “Italy First” or even “India First” etc. However, the nature of these movements is reactionary. Rather than offering a different vision forward, they often offer the impossible return to a glorified and usually inexistent past. Chances are they would eventually consume themselves, not without consequences, before the cycle begins again. It was probably foolhardy to think of globalisation as an unstoppable and perpetually unopposed movement. History often forgets that transition from the primary sector (agriculture) to the secondary (manufacturing), by the process of the industrial revolution, was not without obstacles. In Britain, followers of Ludd (hence Luddites), used to invade factories and break machines. In France they would throw their wooden shoes, called sabot, in the machine to stop production. From there comes the modern word of “Sabotage”!

As we move towards a world which will see Chinese consumers claiming a bigger piece of global wealth, a world where technology continues to minimise distances at a breakneck pace, it is natural that we will see political reaction. It will take time for people to adjust and, yes, generations could be “lost” in the process of repositioning western economies for that new world.

We believe the future will still be more globalised, albeit with hiccups in the road. However, it may not necessarily be the projected straight line from where we are today. The future could very well be an era where competitive advantage and technology lies to the East, where US and western consumers are not the lynchpin and focus of the global economy and where eventually the disinflationary advantages of globalisation will peter out. Perhaps the PBOC will become as important as the Fed, or the dominance of the US Dollar as the global reserve currency will be challenged.

Divergence and asset allocation

As asset allocators, we need to prepare for that future. Already the partial opening of the Chinese market has resulted in the MSCI World and the FTSE including more Chinese mainland shares in their benchmark indices. Already news out of China has a –still unsustainable- leading effect on western stock markets. Over the long term, portfolios should adjust to that reality. Asset allocators should also be ready for more political backlash and more volatility in the road to globalisation. Western countries will not just easily hand over their dominance over the globe which has lasted since Marco Polo published his “Book of the Marvels of The World” in 1300.

What’s more, we would expect at some point to see some new theories regarding portfolio management. Markowitz’s theory has served us well for the better part of the century, but let us not forget it was a new beginning for a financial system that had failed. After 2008 much has changed, including the nature of long term correlations. So it seems there may be need for investors to seek out new theories and new practices in portfolio management.

As for the current market divergence? Research suggests that it is a garden variety bout of divergence. However, because it coincides with a general divergence theme, it has been getting more attention in financial literature than it probably would otherwise. Experience teaches us that it is more typical in the mature part of the cycle which we now find ourselves in, so, given the prevailing trends, we would expect more such bouts of divergence relative to the recent past. Experience also tells us divergence is positive. Convergence, forged and forced by central banks for a period of six years up to 2015, challenged portfolio diversification principles and favoured passive managers. An increase in overall divergence means more benefits from diversification and more opportunities for truly active managers. So far, in an asset allocation, market and even political and historical context, we do not see the current activity as something well out of the ordinary. In fact, what we observe is that as politics take over from central banks, the competitive allocation of assets returns to its previous norms.

Therefore, to answer the original question: What happened to the Synchronised Cycle? It normalised.

Asset Allocation

Staying “Neutral” Equities

We remain cautious on the UK due to uncertainty regarding monetary and fiscal policy in the wake of Brexit. Aside from an underweight UK position we have no strong geographic preferences. In January 2018 the investment committee remained overall bullish on risk assets, recognising that equities continue to offer more value comparative to bonds. It also acknowledged that the risk of a black swan -an unforeseen cycle-ending event- is rising. We thus decided to tactically take some risk off the table, reducing our equity overweight to “Neutral” and place the proceeds in cash. In April, we redeployed some of this cash into Gold, to enhance investor returns in the face of increasing volatility. During our June investment committee we maintained our stance, recognising that nothing has changed in our investment thesis. During our September investment committee, we did not make material changes in our asset allocation. However, we reduced our cash buffer by 1%, allocating the proceeds to short-term bond funds. Additionally, we significantly reduced our weighting in absolute return funds, as we feel that their investment thesis could be significantly challenged in a higher standard deviation environment.

At the beginning of the year, we also reduced the number of funds in the portfolio to increase the focus on those fund managers that make a difference. The underweight in bonds was maintained, as we feel that they continue to be expensive versus equities. We still favour large-caps but are more concerned about high dividend stocks as the global economy accelerates. In the bond space we maintain an exposure in longer dated Gilts and shorter duration corporate bonds, adopting a more ‘barbell’ approach for the fixed income part of our portfolios.